Question_Doc7_15Dec

4-1. You have just taken out a five-year loan from a bank to buy an engagement ring. The ring costs

$5000. You plan to put down $1000 and borrow $4000. You will need to make annual payments

of $1000 at the end of each year. Show the timeline of the loan from your perspective. How would

the timeline differ if you created it from the bank’s perspective?

4-2. You currently have a four-year-old mortgage outstanding on your house. You make monthly

payments of $1500. You have just made a payment. The mortgage has 26 years to go (i.e., it had

an original term of 30 years). Show the timeline from your perspective. How would the timeline

differ if you created it from the bank’s perspective?

4-3. Calculate the future value of $2000 in

a. Five years at an interest rate of 5% per year.

b. Ten years at an interest rate of 5% per year.

c. Five years at an interest rate of 10% per year.

d. Why is the amount of interest earned in part (a) less than half the amount of interest earned

in part (b)?

4-4. What is the present value of $10,000 received

a. Twelve years from today when the interest rate is 4% per year?

b. Twenty years from today when the interest rate is 8% per year?

c. Six years from today when the interest rate is 2% per year?

4-5. Your brother has offered to give you either $5000 today or $10,000 in 10 years. If the interest

rate is 7% per year, which option is preferable?

.

4-6. Consider the following alternatives:

i. $100 received in one year

ii. $200 received in five years

iii. $300 received in ten years

a. Rank the alternatives from most valuable to least valuable if the interest rate is 10% per

year.

b. What is your ranking if the interest rate is only 5% per year?

c. What is your ranking if the interest rate is 20% per year?

4-7. Suppose you invest $1000 in an account paying 8% interest per year.

a. What is the balance in the account after 3 years? How much of this balance corresponds to

“interest on interest”?

b. What is the balance in the account after 25 years? How much of this balance corresponds to

interest on interest?

4-8. Your daughter is currently eight years old. You anticipate that she will be going to college in 10

years. You would like to have $100,000 in a savings account to fund her education at that time. If

the account promises to pay a fixed interest rate of 3% per year, how much money do you need

to put into the account today to ensure that you will have $100,000 in 10 years?

Timeline:

4-9. You are thinking of retiring. Your retirement plan will pay you either $250,000 immediately on

retirement or $350,000 five years after the date of your retirement. Which alternative should you

choose if the interest rate is

a. 0% per year?

b. 8% per year?

c. 20% per year?

Timeline: Same for all parts

4-10. Your grandfather put some money in an account for you on the day you were born. You are now

18 years old and are allowed to withdraw the money for the first time. The account currently has

$3996 in it and pays an 8% interest rate.

a. How much money would be in the account if you left the money there until your 25th

birthday?

b. What if you left the money until your 65th birthday?

c. How much money did your grandfather originally put in the account?

4-11. Suppose you receive $100 at the end of each year for the next three years.

a. If the interest rate is 8%, what is the present value of these cash flows?

b. What is the future value in three years of the present value you computed in (a)?

c. Suppose you deposit the cash flows in a bank account that pays 8% interest per year. What

is the balance in the account at the end of each of the next three years (after your deposit is

made)? How does the final bank balance compare with your answer in (b)?

4-12. You have just received a windfall from an investment you made in a friend’s business. He will be

paying you $10,000 at the end of this year, $20,000 at the end of the following year, and $30,000

at the end of the year after that (three years from today). The interest rate is 3.5% per year.

a. What is the present value of your windfall?

b. What is the future value of your windfall in three years (on the date of the last payment)?

a. Timeline:

4-13. You have a loan outstanding. It requires making three annual payments at the end of the next

three years of $1000 each. Your bank has offered to allow you to skip making the next two

payments in lieu of making one large payment at the end of the loan’s term in three years. If the

interest rate on the loan is 5%, what final payment will the bank require you to make so that it is

indifferent between the two forms of payment?

4-14. You have been offered a unique investment opportunity. If you invest $10,000 today, you will

receive $500 one year from now, $1500 two years from now, and $10,000 ten years from now.

a. What is the NPV of the opportunity if the interest rate is 6% per year? Should you take the

opportunity?

b. What is the NPV of the opportunity if the interest rate is 2% per year? Should you take it

now?

4-15. Marian Plunket owns her own business and is considering an investment. If she undertakes the

investment, it will pay $4000 at the end of each of the next three years. The opportunity requires

an initial investment of $1000 plus an additional investment at the end of the second year of

$5000. What is the NPV of this opportunity if the interest rate is 2% per year? Should Marian

take it?

4-16. Your buddy in mechanical engineering has invented a money machine. The main drawback of

the machine is that it is slow. It takes one year to manufacture $100. However, once built, the

machine will last forever and will require no maintenance. The machine can be built

immediately, but it will cost $1000 to build. Your buddy wants to know if he should invest the

money to construct it. If the interest rate is 9.5% per year, what should your buddy do?

4-17. How would your answer to Problem 16 change if the machine takes one year to build?

4-18. The British government has a consol bond outstanding paying £100 per year forever. Assume the

current interest rate is 4% per year.

a. What is the value of the bond immediately after a payment is made?

b. What is the value of the bond immediately before a payment is made?

4-19. What is the present value of $1000 paid at the end of each of the next 100 years if the interest

rate is 7% per year?

4-20. You are head of the Schwartz Family Endowment for the Arts. You have decided to fund an arts

school in the San Francisco Bay area in perpetuity. Every five years, you will give the school $1

million. The first payment will occur five years from today. If the interest rate is 8% per year,

what is the present value of your gift?

4-21. When you purchased your house, you took out a 30-year annual-payment mortgage with an

interest rate of 6% per year. The annual payment on the mortgage is $12,000. You have just

made a payment and have now decided to pay the mortgage off by repaying the outstanding

balance. What is the payoff amount if

a. You have lived in the house for 12 years (so there are 18 years left on the mortgage)?

b. You have lived in the house for 20 years (so there are 10 years left on the mortgage)?

c. You have lived in the house for 12 years (so there are 18 years left on the mortgage) and you

decide to pay off the mortgage immediatelybeforethe twelfth payment is due?

4-22. You are 25 years old and decide to start saving for your retirement. You plan to save $5000 at

the end of each year (so the first deposit will be one year from now), and will make the last

deposit when you retire at age 65. Suppose you earn 8% per year on your retirement savings.

a. How much will you have saved for retirement?

b. How much will you have saved if you wait until age 35 to start saving (again, with your first

deposit at the end of the year)?

4-24. A rich relative has bequeathed you a growing perpetuity. The first payment will occur in a year

and will be $1000. Each year after that, you will receive a payment on the anniversary of the last

payment that is 8% larger than the last payment. This pattern of payments will go on forever. If

the interest rate is 12% per year,

a. What is today’s value of the bequest?

b. What is the value of the bequest immediately after the first payment is made?

4-25. You are thinking of building a new machine that will save you $1000 in the first year. The

machine will then begin to wear out so that the savingsdecline at a rate of 2% per year forever.

What is the present value of the savings if the interest rate is 5% per year?

4-26. You work for a pharmaceutical company that has developed a new drug. The patent on the drug

will last 17 years. You expect that the drug’s profits will be $2 million in its first year and that

this amount will grow at a rate of 5% per year for the next 17 years. Once the patent expires,

other pharmaceutical companies will be able to produce the same drug and competition will

likely drive profits to zero. What is the present value of the new drug if the interest rate is 10%

per year?

4-27. Your oldest daughter is about to start kindergarten at a private school. Tuition is $10,000 per

year, payable at thebeginningof the school year. You expect to keep your daughter in private

school through high school. You expect tuition to increase at a rate of 5% per year over the 13

years of her schooling. What is the present value of the tuition payments if the interest rate is 5%

per year? How much would you need to have in the bank now to fund all 13 years of tuition?

4-28. A rich aunt has promised you $5000 one year from today. In addition, each year after that, she

has promised you a payment (on the anniversary of the last payment) that is 5% larger than the

last payment. She will continue to show this generosity for 20 years, giving a total of 20

payments. If the interest rate is 5%, what is her promise worth today?

4-29. You are running a hot Internet company. Analysts predict that its earnings will grow at 30% per

year for the next five years. After that, as competition increases, earnings growth is expected to

slow to 2% per year and continue at that level forever. Your company has just announced

earnings of $1,000,000. What is the present value of all future earnings if the interest rate is 8%?

(Assume all cash flows occur at the end of the year.)

4-30. Your brother has offered to give you $100, starting next year, and after that growing at 3% for

the next 20 years. You would like to calculate the value of this offer by calculating how much

money you would need to deposit in the local bank so that the account will generate the same

cash flows as he is offering you. Your local bank will guarantee a 6% annual interest rate so long

as you have money in the account.

a. How much money will you need to deposit into the account today?

b. Using an Excel spreadsheet, show explicitly that you can deposit this amount of money into

the account, and every year withdraw what your brother has promised, leaving the account

with nothing after the last withdrawal.

4-31. You have decided to buy a perpetuity. The bond makes one payment at the end of every year

forever and has an interest rate of 5%. If you initially put $1000 into the bond, what is the

payment every year?

4-32. You are thinking of purchasing a house. The house costs $350,000. You have $50,000 in cash that

you can use as a down payment on the house, but you need to borrow the rest of the purchase

price. The bank is offering a 30-year mortgage that requires annual payments and has an

interest rate of 7% per year. What will your annual payment be if you sign up for this mortgage?

4-33. You are thinking about buying a piece of art that costs $50,000. The art dealer is proposing the

following deal: He will lend you the money, and you will repay the loan by making the same

payment every two years for the next 20 years (i.e., a total of 10 payments). If the interest rate is

4%, how much will you have to pay every two years?

4-34. You would like to buy the house and take the mortgage described in Problem 32. You can afford

to pay only $23,500 per year. The bank agrees to allow you to pay this amount each year, yet still

borrow $300,000. At the end of the mortgage (in 30 years), you must make aballoonpayment;

that is, you must repay the remaining balance on the mortgage. How much will this balloon

payment be?

4-35. You are saving for retirement. To live comfortably, you decide you will need to save $2 million

by the time you are 65. Today is your 30th birthday, and you decide, starting today and

continuing on every birthday up to and including your 65th birthday, that you will put the same

amount into a savings account. If the interest rate is 5%, how much must you set aside each year

to make sure that you will have $2 million in the account on your 65th birthday?

4-36. You realize that the plan in Problem 35 has a flaw. Because your income will increase over your

lifetime, it would be more realistic to save less now and more later. Instead of putting the same

amount aside each year, you decide to let the amount that you set aside grow by 3% per year.

Under this plan, how much will you put into the account today? (Recall that you are planning to

make the first contribution to the account today.)

4-37. You are 35 years old, and decide to save $5000 each year (with the first deposit one year from

now), in an account paying 8% interest per year. You will make your last deposit 30 years from

now when you retire at age 65. During retirement, you plan to withdraw funds from the account

at the end of each year (so your first withdrawal is at age 66). What constant amount will you be

able to withdraw each year if you want the funds to last until you are 90?

4-38. You have an investment opportunity that requires an initial investment of $5000 today and will

pay $6000 in one year. What is the IRR of this opportunity?

4-39. Suppose you invest $2000 today and receive $10,000 in five years.

a. What is the IRR of this opportunity?

b. Suppose another investment opportunity also requires $2000 upfront, but pays an equal

amount at the end of each year for the next five years. If this investment has the same IRR as

the first one, what is the amount you will receive each year?

4-40. You are shopping for a car and read the following advertisement in the newspaper: “Own a new

Spitfire! No money down. Four annual payments of just $10,000.” You have shopped around and

know that you can buy a Spitfire for cash for $32,500. What is the interest rate the dealer is

advertising (what is the IRR of the loan in the advertisement)? Assume that you must make the

annual payments at the end of each year.